In this post, I will show that during the New Deal era, changes in the real economic growth rate can be explained almost entirely by the earlier changes in federal government’s non-defense spending. There are going to be a lot of words at first – but if you’re the impatient type, feel free to jump ahead to the graphs. There are three of them.

The story I’m going to tell is a very Keynesian story. In broad strokes, when the Great Depression began in 1929, aggregate demand dropped a lot. People stopped buying things leading companies to reduce production and stop hiring, which in turn reduced how much people could buy and so on and so forth in a vicious cycle. Keynes’ approach, and one that FDR bought into, was that somebody had to step in and start buying stuff, and if nobody else would do it, the government would.
So an increase in this federal government spending would lead to an increase in economic growth. Even a relatively small boost in government spending, in theory, could have a big consequences through the multiplier effect – the government hires some construction companies to build a road, those companies in turn purchase material from third parties and hire people, and in the end, if the government spent X, that could lead to an effect on the economy exceeding X.

This increased spending by the Federal government typically came in the form of roads and dams, the CCC and the WPA and the Tennessee Valley Authority, in the Bureau of Economic Analysis’ National Income and Product Accounts (NIPA) tables it falls under the category of nondefense federal spending.

Now, in a time and place like the US in the early 1930s, it could take a while for such nondefense spending by the federal government to work its way through the economy. Commerce moved more slowly back in the day. It was more difficult to spend money at the time than it is now, particularly if you were employed on building a road or a dam out in the boondocks. You might be able to spend some of your earnings at a company store, but presumably the bulk of what you made wouldn’t get spent until you get somewhere close to civilization again.

So let’s make a simple assumption – let’s say that according to this Keynesian theory we’re looking at, growth in any given year a function of nondefense spending in that year and the year before. Let’s keep it very simple and say the effect of nondefense spending in the current year is exactly twice the effect of nondefense spending in the previous year. Thus, restated,

For the change in economic growth, we can simply use Growth Rate of Real GDP at time t less Growth Rate of Real GDP at time t-1. The growth rate of real GDP is provided by the BEA in an easy to use spreadsheet here.

Now, it would seem to make sense that nondefense spending could simply be adjusted for inflation as well. But it isn’t that simple. Our little Keynesian story assumes a multiplier, but we’re not going to estimate that multiplier or this is going to get too complicated very quickly, particularly given the large swing from deflation to inflation that occurred in the period. What we can say is that from the point of view of companies that have gotten a federal contract, or the point of view of people hired to work on that contract who saved what they didn’t spend in their workboots, or storekeepers serving those people, they would have spent more of their discretionary income if they felt richer and would have spent less if they felt poorer.

And an extra 100 million in nondefense spending (i.e., contracts coming down the pike) will seem like more money if its a larger percentage of the most recently observed GDP than if its a smaller percentage of the most recently observed GDP. Put another way, context for nondefense spending in a period of rapid swings in deflation and inflation can be provided by comparing it to last year’s GDP.

Put another way… this simple story assumes that changes in the Growth Rate in Real GDP (i.e., the degree to which the growth rate accelerated or decelerated) can be explained by the rate at which nondefense spending as a perceived share of the economy accelerated or decelerated. Thus, when the government increased nondefense spending (as a percent of how big the people viewed the economy) quickly, that translated a rapid increase in real GDP growth rates. Conversely, when the government slowed down or shrunk nondefense spending, real GDP growth rates slowed down or even went negative.

Note that GDP and nondefense spending figures are “midyear” figures. Note also that at the time, the fiscal year ran from July to June… so the amount of nondefense spending that showed up in any given calendar year would have been almost completely determined through the budget process a year earlier.

As an example… nondefense spending figures for 1935 were made up of nondefense spending through the first half of the year, which in turn were determined by the budget which had been drawn up in the first half of 1934. In other words, equation (2) explains changes in real GDP growth rates based on spending determined one and two years earlier. If there is any causality, it isn’t that growth rates in real GDP are moving the budget.

Since there stories are cheap, the question of relevance is this: how well does equation (2) fit the data? Well, I’ll start with a couple graphs. And then I’ll ramp things up a notch (below the fold).

Figure 1 below shows the right hand side of equation (2) on the left axis, and the left hand side of equation (2) on the right axis. (Sorry for reversing axes, but since the right hand side of the equation (2) leads it made sense to put it on the primary axis.)

Notice that the changes in nondefense spending growth and the changes in the rate of real GDP growth correlate very strongly, despite the fact that the former is essentially determined a year and two years in advance of the latter.

Here’s the same information with a scatterplot:

So far, it would seem that either the government’s changes to nondefense spending growth were a big determinant of real economic growth, or there’s one heck of a coincidence, particularly since I didn’t exactly “fit” the nondefense function.

But as I noted earlier in this post, after the first two graphs, I would step things up a notch. That means I’m going to show that the fit is even tighter than it looks based on the two graphs above. And I’m going to do so with a comment and a third graph.

Here’s the comment: 1933 figures do not provide information about how the New Deal programs worked. After all, the figures are midyear – so the real GDP growth would be growth from midyear 1932 to midyear 1933. But FDR didn’t become President until March of 1933.

So… here’s Figure 2 redrawn, to include only data from 1934 to 1938.

While I’m a firm believer in the importance of monetary policy, for a number of reasons I don’t believe it made much of a difference in the New Deal era. As Figure 3 shows, changes in nondefense spending – hiring people to build roads, dams, and the like, explain subsequent changes in real GDP growth rates exceptionally well from 1934 to 1938. This simple model explains more than 90% of the change in real GDP growth rates over that period.

Of course, after 1938, the relationship breaks down… but by then the economy was on the mend (despite the big downturn in 1938). More importantly (I believe – haven’t checked this yet!), defense spending began to become increasingly important. People who might have been employed building roads in 1935 might have found employment refurbishing ships going to the Great Britain in 1939.

—

As always, if you want my spreadsheet, drop me a line. I’m at my first name (mike) period my last name (kimel – note only one “m”) at gmail.com.

I didn’t back out inflation changes so the numbers are probably a little different (% change year over year), but not by much. These were large increases in defense spending and not insignificant relative to GDP..

Mike Kimel

July 20, 2017 9:32 pm

Dan,

Thanks for this post. I had forgotten about it.

Longtooth,

I hesitate to answer you based on past experience, but I don’t seem to learn. When I was writing related posts on the US growth rate post the 1929 collapse, invariably people would show up and explain how it was defense spending that saved the day.

Now, working off memory, the pickup in the economy began in late ’33 and ’34. Look at the figures you wrote down and see whether that squares with the economic growth that was observed anywhere near as well as nondefense spending does.

Longtooth

July 20, 2017 10:40 pm

Therefore, defense spending had nothing to do with GDP growth or decline. Now I see.

Longtooth

July 21, 2017 12:14 am

This is just one paper comparing unemployment rates to defense spending, non-defense spending, & State/Local spending

“Many economists claim that the New Deal has falsely been praised as the panacea for unemployment reduction and economic recovery from the Great Depression (Vedder and Gallaway 1993, Powell 2003, Cole and Ohanian 2004). Instead, the argument goes, the real end of the depression came through the decision of the U.S. to enter World War II (Leuchtenburg 1963, Hall and Ferguson 1998). While the U.S. economy grew strongly during FDR’s first term with the introduction of the New Deal that growth, as shown in Figure 2, was not enough to restore pre-Depression prosperity. Even worse, some of the recovery was undone by the 1938 recession. It was only during the war years (1941-1945), long after both the First New Deal (1933-1934) and the Second New Deal (1935-1938) had been in effect, that the economy recorded growth rates big enough to spell the end of the Great Depression. This pattern holds for unemployment as well.”
Ref: Same link, pages 29, 30, 32

Also see the Figure 2 (page 28) chart for components of GDP from 1929 to 1950. In that chart non-defense spending is miniscule, barely perceptible relative to defense spending. The major growth was in business investment from 1933, dropping slightly only in 1938 (e.g. the recession within the depression).

I only point these things out (defense and other spending) because Mr Kimel doesn’t include defense spending or any other boosts to the economy, thus giving a misleading emphasis and significance to non-defense spending. They show a far greater relation to growth and employment than non-defense spending.

If Keynesian spending by the gov’t is the question then clearly defense spending and state and local spending has to be included.

Full disclosure: I not a fan of U.S. defense spending and oppose it to the degree of spending we actually do. Half as much would suffice, imo.

While I’m a firm believer in the importance of monetary policy, for a number of reasons I don’t believe it made much of a difference in the New Deal era. As Figure 3 shows, changes in nondefense spending – hiring people to build roads, dams, and the like, explain subsequent changes in real GDP growth rates exceptionally well from 1934 to 1938. This simple model explains more than 90% of the change in real GDP growth rates over that period.

Got that? Non-defense spending from 1934 to 1938 explains about the 90% of the variation in the growth rate from 1936 to 1940, which was the period when we got out of the Great Depression.

Also from the post:

Of course, after 1938, the relationship breaks down… but by then the economy was on the mend (despite the big downturn in 1938). More importantly (I believe – haven’t checked this yet!), defense spending began to become increasingly important. People who might have been employed building roads in 1935 might have found employment refurbishing ships going to the Great Britain in 1939.

So…. 1) the New Deal got us out of the Great Depression, but 2) it stopped having such a great big positive effect once we got out. Presumably the growth rate from 1940 to 1945 happened due to defense spending.

That description of events, incidentally, is compatible with the figures you show as well as the regression results you put up. (Though that regression was very dishonest in lumping the WW2 period in with the 1930s. After all, who the heck would expect nondefense spending to affect unemployment when the military sopped up every able bodied man it could?)

And as I noted in the post, its very Keynesian. When there’s a massive downturn, the government should spend spend spend on infrastructure and the like. As soon as the downturn is handled, government spending has a less positive effect and should stop.

JimH

July 21, 2017 8:52 am

Mike Kimel,

Whether it was non-defense spending or defense spending is irrelevant.

Both were deficit spending by the US federal government! Both acted as a stimulus to the US economy.

And in the 1930s, as one increased, the other was decreased.

As a side note, when the federal government perceived that the US economy was in recovery it withdrew some of that stimulus. (And increased taxes) The result was the slackening of growth in 1937-1938. Later referred to as the 1937-1938 recession.

The non-defense spending had not ended the Great Depression.

During WWII 13 million men went into the US military, and defense plants could not find enough workers. Wages were dramatically increased and many young women went to work in those defense plants. Rationing was imposed in 1942. And the combination of high wages and rationing caused the personal savings rate to rocket to over 25%. In 1945 the war ended, rationing was removed, a flood of young men came home to marry, and the couple spend their combined savings to set up their home. Manufacturers shifted to consumer goods and in 1946 the inflation rate was 18%.

Without those accumulated savings the Great Depression would have resumed.

spencer

July 21, 2017 9:32 am

Interestingly, in 1943-44 real civilian GDP — real GDP less military spending — fell -18.4%and -14.8%, respectively. Total real GDP growth was 16.4% and 8.1%. For example,no civilian autos were built in 1843-44. So it was easy to see why there was massive pent-up demand at the end of the war.

The drop in civilian real GDP was about the same size as the drop in real GDP in the 1930-33 recession.

Mike Kimel

July 21, 2017 9:54 am

Jim H,

Real GDP growth for 1934 to 1937 was 10.8%, 8.9%, 12.9% and 5.1%, respectively. There hasn’t been a single year with so much as a 5.1% as a 5.1% growth rate since 1984. We haven’t hit 8.9%, let alone double digits, since 1943. Saying we slowed down… yeah, so? Exactly how fast and for how long were you expecting? If a leprechaun wanders over and hands you a pot of gold, your reaction shouldn’t be to berate the leprechaun about the workmanship of the pot.

Also the difference between building roads and building Sherman tanks that get used in Europe doesn’t show inthe short term. But the roads don’t get as easily depleted and continue to help growth going forward.

So you admit that Real GDP growth had sagged in 1937. (by more than half.)

But somehow you are missing the fact that Real GDP growth of 10.8%, 8.9%, 12.9% and 5.1%, all represented growth from an absolutely abysmal level of economic activity.

If we had been in a similar condition in 1984 then our Real GDP growth would have been much higher.

I would also prefer that we build roads but that was not what was happening in the first half of the 1940s when wages were very high and rationing was causing personal savings to be over 25%. Those accumulated personal savings and pent up demand caused by rationing, drove the manufacturers to change over to producing consumer goods.

President Roosevelt’s administration’s spending during the mid 1930s never allowed for very high wages nor very high savings rates. Nor did he impose rationing. And the Great Depression did not end in 1937.

From: http://www.bea.gov
National Data —— Table 2.1. Personal Income and Its Disposition
(You will have to select Modify and Choose ‘Annual’ and ‘Select all years’)
Line 35 shows “Personal saving as a percentage of disposable personal income”.
1941__1942__1943__1944__1945
13.9___26.2__27.7___27.9__22.5

JimH

July 21, 2017 12:25 pm

Mike Kimel,

Let me make it clear that war is not the answer.

The answer to depressions is that they should be prevented. Excessive personal debt formation should be prevented.

But the once depressions take hold only very high wages and disincentives to bank lending will reverse the economic course. They must be high enough to eliminate anything remotely like excessive personal debt.

Charles E Persons wrote ’Credit Expansion, 1920 to 1929, and where he documented the debt accumulated before 1929 due to the new installment loans. (From: Quarterly Journal of Economics – November 1930)

From that article: “The essential point here is that during the period of introduction of these new financial devices and while the newly opened reservoirs of credit are filling, we have a temporary increase in the nation’s purchasing power. A combination of circumstances has rendered this expansion of large dimensions in the decade just closed. While the new credit is expanding to its justified limits, more than the normal of commodities may be sold. The industries affected are stimulated to expand their productive capacity and to build up their labor force to the level set by this temporary bulge in consumption. In the working out of competitive forces their great prosperity leads to expansion even beyond this limit as over-eager producers seek an enlarged share of the market and profits. Once the newly developed credit resources reach maturity, new debt created is balanced by installments due on previously assumed obligations. The nation can buy only such volume of goods as is covered by its current income.

I believe that we are currently living through the problems caused by our own new financial devices of credit derivatives and securitization of mortgage debt by private bankers. And very low Fed Funds rates made the problems worse.

Mike Kimel

July 21, 2017 8:37 pm

Jim H,

From 1929 to 1933, real GDP in 2009 dollars fell from 1.056 trillion to 778.3 billion or 26%.

By 1937 it was back to 1.114 trillion. It was back past the high water mark after growing at an insane and unsustainable (for peacetime) pace.

Now, data only goes back to 1929. But if you think it was the bounce back that caused the big growth rate from 1933 to 1937 then feel free to explain why other bounce back periods don’t also Occur. For example, why hasn’t growth since the Great Recession been anything that cannot be described by words like lackluster and mediocre? Sure, the Great Recession was a much smaller affair but we haven’t even gotten in spitting distance of 3% a year real growth in any individual since then.

Bounce back theory simply doesn’t fit any of the data. Something else happened from 1933 to 1937.

As to savings, I don’t know. I honestly am not familiar with that data. But I don’t think this is a bit misleading

I would also prefer that we build roads but that was not what was happening in the first half of the 1940s when wages were very high and rationing was causing personal savings to be over 25%.

I pulled net private savings from line 3 of NIPA table 5.1 and divided it by GDP. From 1938 to 1941, it more than doubled every other year, going from 3% to 13%. It peaked at 22.3% in 1942, and held steady through 1944. To me that isn’t sufficient to say that it wasn’t just peaking a trend that had started in 1938. After all, without the war, had the trend continued, by 1943 the earlier trend would have been somewhere above 28% rather than around 22%.

JimH

July 22, 2017 9:39 am

Mike Kimel,

“By 1937 it was back to 1.114 trillion. It was back past the high water mark after growing at an insane and unsustainable (for peacetime) pace.
Now, data only goes back to 1929. But if you think it was the bounce back that caused the big growth rate from 1933 to 1937 then feel free to explain why other bounce back periods don’t also Occur.”

First I note that there was no appreciable increase in Real GDP from 1929 to 1933.

The cause of the increase in Real GDP from 1934 to 1937 was the huge increase in the amount of federal deficit government spending which began in 1933. That federal deficit spending put money into the hands of consumers and they spent it. But that did not mean that the private economy had dramatically improved. The problem in the private economy was only being masked. And the changes were not self sustaining.

Note in this table that the federal government dramatically reduced the amount of deficit spending in 1937 from -5.4% to -2.5% and then in 1938 it to -.1%. That is what seemed to put the economy back into recession. And personal savings would never have increased under those conditions.

By 1935 Germany had begun to rearm and rapidly increased the size of its military. In 1936 German moved troops into the demilitarized Rhineland. It was obvious that Germany was on a path to war. This served as a wake up call to the American government. The US Army did not have a single armored division. So war material production began to rapidly increase. Some of it went to England but most of it was used to modernize the US military.

And with that you can see the federal government again rapidly increase the nation’s deficit spending. Without the war, the federal government would never have returned to the higher deficit spending. It would have raised the deficit little by little until the apparent recession receded. Again personal savings would never have increased so dramatically under those conditions.

The Great Recession is different. The banks are backstopped by the FDIC and the social programs of Presidents Franklin Roosevelt and Lyndon Johnson are pumping a lot of federal dollars into the economy. Then add President Obama’s stimulus, limited as it was.

So the economy could not fall as far. Since the economy did not fall as far, there would not be the dramatic increases in Real GDP growth.

But our Real GDP growth may continue to be low because Global Free Trade has been another source of economic impairment to the US economy and it is continuing.

So the economy began to change in two ways in about the mid 1990s. Global Free Trade began to more seriously impair consumer incomes and our new financial devices allowed consumers to spend more than they earned. (New financial devices – Charles E Persons)

Sorry for the length.

Longtooth

July 22, 2017 9:36 pm

Mr Kimel,
If you’re trying to show non-defense spending created the economic recovery to bring the US out of the Great Depression, then you have to compare non-defense to defense spending changes (which was a larger proportion of spending).

What purpose or agenda is served by leaving out a major (& larger) proportion of federal spending?

The other obvious issue is that the recovery was only through employment and wages/salaries, so how do you differentiate employment / wages/ salaries between non-defense and defense spending. Defense spending plays its way through the entire economy from mining, steel and iron production, and all the job shops supporting use of the steel and iron, ship building, aircraft constructions, vehicle production, tires, engines, etc. Those jobs are generally in the skilled class (at that time) and thus paid higher wages and salaries than the CCC. The higher incomes were spent for more groceries, consumption of all kinds of goods supporting more incomes.

When defense spending dropped in 1937/38 the economy went into recession. This supports defense spending as a significant proportion of employment and source of wages and salaries being pumped into the economy.

So it isn’t at all clear why you left it out since you can’t differentiate GDP changes between defense and non-defense spending. If you think non-defense accounts for 90% of the changes in GDP, then only 10% can be associated with defense spending which was larger. So did the employees of defense contractors just stick all their money under their mattress?

Longtooth

July 23, 2017 12:09 am

Mr. Kimel,
The following shows the relation of Defense to Welfare spending in the period of interest during the Great Depression. Agricultural spending also increased substantially for food stamps and food kitchens for the most needy and unemployed. The foods were purchased by the Federal gov’t from farm surpluses and thus aided incomes of farm labor only, which was throughout the depression a small proportion of employment.

It shows that Defense spending far outweighed the other federal expenditures in the New Deal jobs markets (FERA, CCC in mid 1933 to YE 1935, followed by the WPA in 1935). The WPA was the primary jobs program. It reached peak employment in 1938 of 3.4 million.

The WPA operated from mid 1935 to 1943 A total of nominal dollars spent between 1935 and June 1941 was $11.4 Billion. On an average annual basis that’s $1.9 billion/year. Over that same period Defense spent $19.8 Billion Thus Defense spent 1.7x as much as the WPA.
Source: https://en.wikipedia.org/wiki/Works_Progress_Administration

Agricultural spending increased beginning in 1933 for food-stamps and food kitchens, operated by the States. In 1939 and 1940 it increased again for GB foods. The federal gov’t Ag spending bought farm surpluses, which aided the farm labor sector while providing the surplus to the massively unemployed needy families. .

Agricultural spending increased beginning in 1933 for food-stamps and food kitchens, operated by the States. In 1939 and 1940 it increased again for GB foods. The federal gov’t Ag spending bought farm surpluses, which aided the farm labor sector while providing the surplus to the massively unemployed needy families. .

Social welfare expenditures were 48.6% of total government spending by 1935, and 49% in 1940. The other 51% didn’t all go to the military either. Table 1443 shows defense outlays were 1660/9468 or about 17.5% of total federal outlays.

But there are other issues with you comment. You mentioned the WPA which was a fine program. Does money spent building a road in New Jersey provide a bigger boost to the US economy than money spent firing off artillery on a range somewhere in Missouri? And that’s not to say firing off that same artillery in, say, the Philippines. I’m going to guess a fair amount of the materiel used by US personnel abroad was locally sourced which, given trade patterns in the 1930s, probably means that such spending had something very close to a zero benefit to the US taxpayer.